Problem #2: How would your answer to Problem #1 change if the debt was unsecured? Specifically, what might the credit rating be under an unsecured format and how would this affect the value of the firm? Explain or provide your reasoning.
Problem #3: How
would your answers to Problems #1 and #2 be affected by the
percentage of insider ownership of equity and what life-cycle stage
the firm is in? Explain or provide your reasoning.
1. Value of firm before expansion= Earnings after tax/ WACC
= $40 million*(1-.25)/ 10% = $ 300 million
2. Value of firm after down credit rating= $40 million*1.2*.75/11.5% = $313.04 million
3. if the debt is unsecured, it would usually lead to a further increase in the weighted average cost of capital due to increased risk to the lenders thereby increasing the expected return by the lenders or providers of funds.
Impliedly, it would lead to falling in the value of the firm since WACC will increase i.e the denominator will increase leading to falling in the value of the firm in case of capital expansion.
thus, the credit rating will also consequently fall.
3. earlier, the debt was 30% of the total capital thereby meaning that 70% of the capital is equity but after capital expansion by way of debt, the equity share will fall down to 60%(since debt is 40% of the total capital).
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